Funds That Make Lemonade

By

Michael Santoli

Updated March 5, 2001 12:01 a.m. ET

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I t must be that some small subset of drivers chooses what car to buy based solely on its crash-test rating, effectively letting a portion of auto makers' ad dollars go to waste by leaving aside all aesthetic, emotional, prestige and performance concerns. This represents decision-making guided only by a fear of a potential adverse future event that would seem beside the point for most road-loving Americans.

Investing in a mutual fund solely because it appears unlikely to run shareholders into a ditch by throwing off heavy taxable-gains distributions is similar, elevating what's typically a secondary concern to top-priority status. Going the extra step and prowling for funds that have a cache of realized tax losses that can offset any future gains might strike the performance-hungry investor as doubly perverse, like buying that ultra-safe car and then encasing it in armor.

But being mindful of the embedded tax liabilities or assets that lurk within funds nonetheless makes sense, and can help steer an investor to the better of two models that appear to be similar. It happens that at the current political and financial moment, many folks have taxes on the brain already. In part, it's because the President took 50 minutes of prime time last week to remind the citizenry how many zeros are in $1.6 trillion and to wax maudlin about the legions of waitresses who might find overtime worthwhile if income taxes were cut by such an amount.

Investors have additional reasons to be seeing tax statements in their sleep, after a year in which many stock funds saddled them with taxable capital-gains distributions even as the funds themselves lost value. Beyond that unwelcome trend, the SEC has written rules that would force fund companies to disclose hypothetical after-tax performance numbers, along with standard pretax returns, thus exposing the differences among managers when it comes to tax efficiency.

With the stock indexes approaching the one-year anniversary of their all-time peak, having dropped anywhere from 7% (the Dow Industrials) to 58% (the Nasdaq), it's likely that funds are sitting on either much smaller embedded gains than they were a few months ago or have, in fact, harvested losses. (Tax losses can be used to offset future gains over several years.) So something vaguely positive has come of the nasty upending of the markets, even if rejoicing in this blessing is a bit like emerging after a tornado has struck to cheer the abundance of firewood.

Ross Levin, president of advisory firm Accredited Investors in Minneapolis, says that with the market churning and swooning so energetically, "the embedded gains in funds can be really fluid. You can probably pick off some good funds" by surmising which hard-hit portfolios might have had their latent taxable gains cut since the last report. He cites
Kopp Emerging Growth
, a once-hot growth fund that's suffered badly from its heavy positions in some former highflyers that were punished in the latter rounds of the rolling tech selloff. He notes that Morningstar cited a 55% embedded gain exposure as of January 31, but with the fund now down 23% on the year, much of that likely has evaporated.

He cautions that, when looking for funds with accumulated losses, "you have to be sure you're not just buying some pig."

Of course, losses pile up because a manager has made some wrong moves, so investing with him or her might not be the greatest idea if there's a chronic style flaw or stockpicking problem. And poor performers tend to face investor redemptions, which can exacerbate lousy returns by forcing more selling. That's why simply grabbing one of last year's cellar-dwelling Internet funds at random for the tax losses isn't such an attractive prospect.

Yet there's a unique case that would appear to escape those concerns. FPA Paramount, a $70 million small-cap fund run by First Pacific Advisors in Los Angeles, had a stretch of wretched performance for years under prior manager Bill Sams. Eric Ende, who along with Steve Geist took over late last March, says that entirely turning over the portfolio has resulted in tax-loss carryforwards totaling $180 million. That's a huge kitty that virtually assures no taxable gains will come around for the next seven years.

Ende and Geist also run FPA Perennial, another small-cap vehicle that beat the broad market in both 1999 and 2000. FPA Paramount is about flat on the year so far, and since the new managers put their picks in place around mid-year 2000, its performance has rebounded smartly. Whereas the prior manager ran a very concentrated fund stuffed with a huge gold-stock position and lots of cash, Ende and Geist look for quality companies with high returns on capital and low debt levels, whose shares trade at modest prices. The portfolio's average multiple is 14 times the holdings' earnings for the trailing 12 months.

Certainly, the fund is a huge recovery project until the managers decisively prove otherwise. But the trends are pointing in the right direction, and all with a huge tax cushion built upon the misfortune of longtime and former shareholders.

I magine if Mr. Potter, the Scroogelike miser in It's a Wonderful Life , were a benevolent wielder of capital who teamed up with a celebrated rescuer of sound but struggling thrifts to fortify the Bedford Falls Building & Loan, rather than attempting to ruin it.

The scenario would be something like what's happening with
Finova
, a benighted consumer lender, which last week agreed to a bailout by the team of Warren Buffett's
Berkshire Hathaway
and
Leucadia National
, a New York financial company that specializes in workouts. To Larry Pitkowsky, co-manager of the
Fairholme
fund, the pairing represents not just a formidable melding of smart money and shrewd operators, but it's a deal that echoes loudly within his fund. Fairholme is a tiny fund of $19 million run out of Short Hills, New Jersey, and it's had an excellent run since its launch in late 1999. With a huge commitment to financial stocks and a slant toward buying bulletproof value names, the nondiversified fund gained more than 46% in 2000 and is breaking even this year.

Berkshire represents a giant slice of the fund, close to 25%. Leucadia, a low-profile but well-respected insurer and lender with a knack for turning around financial firms that hit hard times, takes up nearly 5% of the portfolio. That's two companies amounting to almost 30% of the fund joining together to affirm implicitly the consistency of Fairholme's investment standards.

Pitkowsky characterizes the fund's approach as owning "a handful of companies we think we can understand, run by people we admire" with attractive economic attributes like high returns on capital. That brought the managers last year to the property-casualty insurance sector, where a belief that the industry's pricing picture was improving enabled them to play a pronounced rebound. That area, even after becoming one of the better performers in the market last year, still has upside, says Pitkowsky. "We think you've got another two years to go with rates firming," he offers.

As for the Finova deal, he says it's not terribly surprising, given Leucadia's eye for turnarounds and Berkshire's role of late as a last-resort, iron-gutted supplier of capital. In this case, it seems the townsfolk won't need to pony up to save Finova.

A s the Finova situation underscores, there's almost always someone willing to step in and take control of most any company -- at the right price. At a time when stocks have been stuck in a downward spiral and many are flashing "Cheap," locating future takeover targets is a way of making a buck independent of the market's direction.

To make some hay even under the market's currently clouded skies, Enterprise Group of Funds last week launched the Enterprise Mergers & Acquisitions fund, which is being run by Mario Gabelli, chairman of Gabelli Asset Management and longtime seeker of buyout bait.

Gabelli will sniff around the market for his 50 best takeout candidates for the next year to 18 months and buy them for the fund in hopes of cashing out on deals that come about. Another portion of the portfolio will be devoted to merger risk arbitrage, in which investors try to capture the spread between the trading values of partners in announced deals. This is typically done by buying the target company's shares and selling short those of the acquirer.

A proponent of divining value stocks by calculating how much a private buyer would pay for a company, Gabelli trumpeted his expectation of heavier acquisition activity in the Barron's Roundtable in January. He figures the impending change in accounting rules that will free companies from amortizing goodwill against reported earnings will prime the merger pump. Meanwhile, a streamlining of the antitrust-approval process ought to have a similar effect, he said in January.

At the time, Gabelli was talking up a handful of media companies as probable buyout prospects, including the publishers
Pulitzer
and
Journal Register
and broadcasters Ackerly Group and
Gray Communications
. He also picked chemical maker
Hercules
as a possible seller, and since then
International Specialty Products
has tried to nudge the company into play by offering to buy a big chunk of it and calling for the elimination of Hercules' takeover-defense provisions.

The arbitrage strategy, whose principal risks are deals that fall apart and delays in the closing of transactions, stands to lend stability to the fund's performance. The only mutual fund that pursues deal arbitrage exclusively is the
Merger
fund, and it has produced remarkably steady returns. The $1.1 billion fund aims to earn 10% a year, but has gained 17% or so in each of the last two years, and boasts much lower volatility than straight stock funds.

Merger arbitrage is a popular tack for hedge funds, which have the advantage of being able to boost returns by taking on lots of leverage. Now Enterprise, a division of MONY Group, is letting the little guy into the game for $1,000 a pop.

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